Two-pot retirement system – why advice is so important

The new two-pot retirement system was introduced with two objectives. One of these is to combat our failure to preserve our retirement savings before retirement as many members withdraw their savings when they change jobs.  

The second objective is to allow you, as a member of a pension or provident fund to access your retirement savings in times of financial distress without resigning from your jobs.

While providing this access presents a short-term cash-flow solution, as a member you need to understand the tax implications, as well as the long-term impact of such withdrawals on your savings at retirement and the income those savings will provide.

Tax consequences

Withdrawals from the savings component within your retirement fund will be added to your taxable income and taxed at your marginal tax rate. Being taxed at the tax bracket rates is very different from how cash lump sums are taxed at retirement and the implications should be considered before any withdrawals are made.

Let’s assume, for example, Sam currently earns R25 000 a month, that is R300 000 a year. Sams highest marginal tax bracket is 26 percent.

Let’s assume it’s a few years into the two-pot system and Sam’s savings component has grown to R80 000 and Sam decides to withdraw it all. It will increase Sam’s taxable income for the year to R380 000, which moves Sam into a higher tax bracket.

The table below shows the tax payable with and without the withdrawal:

THE TAX IMPACT OF A SAVINGS POT WITHDRAWAL
Taxable income for the year	Tax payable for the year
R300 000	R41 797
R380 000	R63 072

That’s additional tax of R21 275 on a withdrawal of R80 000, which is 27 percent of the amount you withdraw.

The cost of this withdrawal therefore amounts to more than a quarter of the amount withdrawn, while this same amount at retirement could be paid out tax-free.

If Sam needs R80 000 after-tax, an amount of more than R100 000 will need to be withdrawn to achieve this, resulting in even more tax payable.

Lost time in the market

Members also need to consider the opportunity cost of withdrawing funds from their retirement savings, and the younger you are, the greater the loss of potential market returns on the amount withdrawn.

Consider the same example in which Sam, aged 40, withdraws R80 000. Sam’s retirement savings are invested to achieve an average annual return of 10 percent over the long-term and Sam’s retirement date is at age 65.

To consider the opportunity cost of withdrawing R80 000, you have to work out what that R80 000 could have grown to by retirement and the potential growth that Sam will forfeit making the withdrawal today:

• R80 000 invested at 10 percent growth a year over a 25-year period would amount to R866 776 at Sam’s retirement age of 65.
  
  
• If the inflation rate is six percent, the R866 776 at retirement would be the equivalent of R201 958 today.
  
  
• That is R121 958 more than the R80 000 or 152 percent of the R80 000 withdrawn. This is the growth that Sam forfeits by making the withdrawal, without even considering the tax implication of 27 percent.

The purpose of your withdrawal

Being in financial difficulty is stressful. As humans, we tend to react emotionally and may not always consider the full consequences of the decisions made.

That is why it is important to seek advice before making the decision to withdraw from your retirement savings and to consider if the benefits outweigh the cost of withdrawing.

No one wants to have debt and it may make sense to withdraw from your retirement savings to settle outstanding debt, but there are different types of debt which come at different costs.

It is important to consider the cost of paying off your debt versus the cost of withdrawing from your retirement savings.

In addition, you could look at using some of the cash you free up by paying off debt and not having to make a repayment, to make an additional contribution to your retirement savings each month. In other words, you add back what you withdraw to put yourself in the same position you would have been at retirement.

A financial planner can assist with assessing the feasibility of the various options.

Work with a financial planner

Before making withdrawals from your retirement funds, seek the help of a financial planner or financial coach to work through your monthly cash flows and possibly develop a new budget or debt management plan.

Given that such a low percentage of South Africans are able to retire comfortably, it is important to try and preserve as much of your retirement savings as you can. There may be other alternatives that do not impact on your financial future.